PRINT THIS PAGE

Institutional investor profile: Stefan Hepp, CEO and Founding Partner, Strategic Capital Partners

Hepp on the bulging secondaries market, on the risks of niche investing, on the dangers of over-commitment and on why many institutions will simply stop investing in private equity over the medium term.

Based in Switzerland, Strategic Capital Management is a gatekeeper for some of the major Swiss insurance companies and public and private pension funds. It manages CHF2bn in its private equity programmes and has around CHF100m in discretionary accounts for smaller Swiss investors. It invests across the private equity spectrum both in terms of stage and geography. The firm was set up in 1996 by Hepp and Benedikt Schurch, who had worked together at Morgan Stanley as head of Swiss institutional business and head of asset management respectively.

Why did you set up Strategic Capital Partners?
‘We set out to run an advisory service for institutional investors that was free from any sort of conflict of interest or product. When we started advising on alternative assets in 1996, it was not an established asset class for Swiss institutions. So we did a number of strategic planning projects in which we analysed the impact of various alternative asset classes on institutional portfolios. We looked at how much they should invest, how they should diversify their portfolios and what levels of risk they should expect from that. What emerged from that was that the institutions needed help in implementing those investments. That led to our firm specialising in this area and acting as a gatekeeper and advisor for the planning and implementation of private equity portfolios.

‘We help our clients in the development of their asset allocation strategy, their commitment budgeting and the identification of suitable partnerships for them to invest in, including the due diligence and negotiation.'

What type of investments do you look for?
‘We invest broadly across all sectors globally - that means that we invest across the US, Europe and Asia. We have scaled down our Asian weighting from a previous level of eight per cent to closer to five per cent and it will come down to three per cent. And then, depending on the client, our weighting between Europe and the US is 50-50.

‘We have been very careful in our venture capital allocation. This was set a few years ago in the range of ten to 30 per cent. Until recently, many regarded this as a low allocation. We have been criticised in the past by people who felt that we were missing the venture boat. In our opinion, that low allocation is the reason that, today, our investors continue to invest in private equity. Their returns have been much more stable than they would have been had we invested more in venture. We managed to avoid some of the excess that was apparent in the venture sector.

‘We also look at secondary investments. We don't invest in them in a major way, but we consider them to be an interesting asset class. We are concerned, however, about the amount of money that is being poured into the market. We fear that the large secondary players are getting too aggressive on the pricing. We are nonetheless happy about secondaries investments that we have done in the past. They have allowed us to invest in funds in the early 1990s before SCM started investing in private equity. We prefer to focus on buy-outs in our secondary investments, but this is not always possible because the partnership agreements do not bind the funds in any way and because the secondaries market is, by its very nature, opportunistic.

‘We are sometimes offered co-investments. We often find them interesting, but we haven't, as yet pursued any of them. Our clients don't have the process in place to make this type of investment.'

What determines your geographic allocation?
‘We weight different stages in Europe and the US. We are a larger venture capital investor in the US than in Europe. There is simply more venture capital talent, more experience and the exit markets are better developed in the US than in Europe. Currently we believe that European buy-outs are more attractive. At the large buy-out end, European industry still has a lot more restructuring to do; the US has already completed this phase. As a result there are a lot of corporate divestiture opportunities. There are also a lot more government assets for sale, and that includes telecoms and postal services that have been privatised and that are selling off parts of their business - these is creating a lot of opportunities in Europe. Another reason for the attractiveness of the buy-out market in Europe, compared to the US, is the debt markets. Capital is available at more reasonable prices and this has a direct impact on the attractiveness of a deal from the LP's perspective.'

Why are you scaling back in Asia?
‘We have decided to scale back our Asian investments for a number of reasons. It is a very difficult market. In most of the Asian markets, there is no transparency, firms are unable to do maturity deals or to focus on clear exit strategies. There are no local exit markets there for the technology-focused venture funds - there is no NASDAQ equivalent, for example.

‘Remember, too, that Asia is not one market. If you give money to Asian managers, you are giving them an investment brief that includes a number of different countries, each with their own issues. You cannot look your investors in the eye and tell them that you have checked through all the tax and legal implications of investing in each of the markets.'

Which are areas do you actively avoid?
‘We like broad-based teams with a demonstrated ability to react to changing opportunities throughout the cycle by having expertise in different sectors and different ways of creating value in companies. We are not keen on overly specialised funds that look just at, say, a small niche in technology or a small area of mid-market buy-outs. The risk is that you find yourself trapped in a corner because the opportunities may not be there for a few years. That is just too risky.

‘We also avoid very small funds because our clients do not want to take too large a stake in each partnership. The optimal size would be a ten to 15 per cent weighting in a fund.'

How do you find out about good opportunities?
‘We have a very good network of contacts in Europe and the US. We are also able to talk to fellow institutions - we exchange ideas and deal flow. We get approached by all the major placement agents. And a lot of funds know us and come directly to us. If they don't know us, then they would recognise our clients and so they would come to us anyway. Our general partners also sometimes give us ideas. Altogether, that brings us a dealflow that runs to around 200 partnerships a year (excluding all those that just aren't suitable for us). Out of these 200, we would enter into a dialogue with about 30 and then we would invest in around ten to twelve.'

What do you look for in a private equity firm?
‘We like to see a good generational mix, a firm that we would be happy to work in if we were in that business, we like to see that the younger partners are being groomed for the future, we like to see that those responsible for past track records are still involved in the business. We like experienced teams. We also like to see that a firm is able to get rid of those people who are not so successful. Every fund has investments that they don't like to dwell on and if you discover that one partner had more than his fair share of these investments, you have to ask why he is still a partner. You sometimes even find that these people get the second largest share of the carry, for example. That is pretty demotivating for the guy further down the organisation that has more than his fair share of good investments. We look at issues such as this because it is important for team stability.

‘We also like firms that are better staffed than the average. We don't invest in the three guys and a dog-type firms. Seven companies per partner makes us nervous. Having one extra partner than is usual by industry standards is no bad thing. It means that you have more hands on deck if you encounter stormy weather.'

What is your appetite for first-time funds?
‘We will look at first time funds if they are not first-time industry participants and if they can demonstrate experience in just the same way as any other, more established firm. We have invested in a few first-time funds, but they do not make up a significant part of our portfolio. This is partly because we have seen so many me-too funds springing up. We have seen a lot of people in this area that have never exited an investment but have based their track record on strong valuation gains. We also know that there are team risks with these funds. We know because we have set up our own firm. The chemistry between the team is so important. If you work together for a number of years, it's similar to a marriage in that all those things that you don't like about your partners become more of an issue every year. You have to be able to live with that and know how to handle that. So we would be sceptical of a fund managed by people who had not worked together before.'

What is the biggest mistake that you have made?
‘We have invested in captive teams in the past that have proven how strong an asset independence is in private equity. That is something we regret.'

What advice would you offer to a new private equity investor?
‘They should think twice. To be successful in private equity, you have do it for a long time. If you are working in an institution, you need strong support and that requires education. Those who invest in private equity without that expertise and go in just because everyone else is are the ones that are likely to abandon ship when the bad weather comes.

‘Investors need to learn about private equity, run through scenarios, calibrate their programmes so that, even if the markets are unfavourable, they have room for manoeuvre. Only then will they stick with it. If they don't stick with it, then they will be getting out at exactly the wrong time. They will have had a bad experience and will not re-enter for years to come.

‘Beware of over committing yourself, too. We are highly sceptical of all the talk about over-commitment over the last few years. You cannot predict the future with models. There is no way of knowing how much will be drawn down in 2005. General partners don't even know how much money they will need over the next three months - they can never know for certain whether they will complete a deal until it's all signed. We believe in stretching out private equity programmes over many years because we also use models to budget our commitments. But we take the view that models are always wrong and so we track how an investment is going against the budget and react accordingly.

‘So at the moment, for example, we are going through a period in which we anticipate longer holding periods, in which distributions are scarce and in which investments are beginning to pick up. At the same time, the assets of the client may have shrunk because of the overall market conditions. If you have been too ambitious in your over-commitment strategy, then you are now in a difficult position. You are unable to commit any more and your overall assets may well have shrunk. It's a great environment for secondary buyers; it's not a great environment for continuous private equity programmes. So you need to be careful. Always leave yourself breathing space to allow you to continue if times get tough.'

What irritates you about the private equity market?
‘Fees, fund sizes and the herd mentality. At the moment we are seeing a total abandonment of venture capital and a stampede into secondaries that are buying into venture capital partnerships that you would not have wanted as primaries. These will only work out if the market improves. If things go bust, it doesn't matter if you got it at a 30 per cent discount or not. We get irritated by this kind of thing - a mass movement from one theme to another.

‘We also get irritated by the reluctance of firms that are evidently too big to face the fact and repay the capital to limited partners. Some firms have done this, but it's at a pretty meaningless level when you compare it to the amount of uninvested capital washing around the market. It's a first step, but it hasn't changed the overall picture so far.'

What is the biggest issue in the private equity market?
‘There are two big issues. One is to get distributions back up and that is clearly out of the hands of managers. Underlying this is the fact that managers must now prove that they can be successful in growing companies over the long-term as well as buying and selling within three years. That means they must be able to manage companies over seven to eight years and implement an accordingly long business programme. If you are able to that, then you still have value in your portfolio. Your clients may become frustrated because distributions are taking longer than they had expected, but they will be happy with the end result.'

How do you think that the market will change in the future?
‘A lot of funds will disappear. There will be a dramatic drop in commitments from investors. We are just conducting a study on that at the moment and we are seeing that certain classes of investors will be out of the market for a long time. In the US, around 50 per cent of the investment community has a high level of private equity commitment. Many of them are suffering from a lack of distributions and the collapse of their public equity portfolio values - they have overshot their targets and they do not have permission to run ten or 15 per cent in private equity if the target was eight per cent. They will have to redress that. In Europe, investors have much lower targets. They are equally affected by drops in their portfolio values, but they are still below their targets and could continue investing in private equity. However, they need to work out the value in terms of diversification of their portfolio. There are a lot of question marks over whether private equity is worth it - their experience is much shorter than that of funds in the US. So in the US, you have institutions that fully believe in the potential of private equity, but can't hold on any more; in Europe many institutions are still unconvinced. So that retrenchment will be felt in the market.

‘We are also seeing a polarisation in the market. Some funds are raising $4bn; others have difficulty closing on $100m. Sometimes this is justified, but it also means that the funding of certain sectors of the private equity market is disparate. There is a lot of money at the top end. I'm not saying that there aren't any opportunities at the top end, but there is a clear death of capital at the mid-market end.

‘Private equity houses will have rather more room than they have had recently. By that I mean that a lot of structural competitors, such as commercial bank funds, to some extent insurance direct investment arms and funds set up by investment banks will disappear. That is good news. They are the sort of competitors who do deals if they think they can make seven per cent, while the guy who wants to make 20 to 25 per cent is dropping out because he can't match it. The disappearance of that type of investor should ensure that there are more opportunities for private equity firms.'

Copyright © 2002 AltAssets